When it comes to buying and selling a business, the price is usually the most negotiated part of the deal. Often we find that the parties agree a payment structure without including their solicitors or accountants. The optimum position for a seller will be that the purchase price is agreed and fixed with all monies payable at completion, however there are three main price adjustment mechanisms that are commonly used in the purchase of a business. The use of these depends on the individual facts of the purchase and the respective bargaining positions of the seller and buyer.
1. Completion Accounts
The Mechanism
Completion Accounts are a special set of accounts drawn up after completion has taken place. The price is adjusted depending on whether the final figures in the Completion Accounts are higher or lower than the estimated figures in the agreement used to calculate the purchase price paid on completion.
Why this method?
This method is seen as a buyer friendly mechanism. It provides a purchase price determined on the actual position of the business. It is good to use when the financial position of the business is likely to change or has regular variations such as a particularly seasonal business.
Pros and Cons
Pros
- The transaction may complete more quickly using this method as there will be less due diligence required of the accounts before completion.
- It can help those parties reach a price where they are struggling to agree.
- The seller retains the benefit of the businesses profits until completion.
- The buyer pays for exactly what it is buying due to the price adjustment.
Cons
- There is a delay in ascertaining the final price.
- There are further costs incurred for the preparation of the accounts.
- There could be a dispute over the accounts which incurs more costs and delays any additional payments.
2. Locked Box
The Mechanism
The locked box is where a fixed purchase price is calculated on a specific date based on the balance sheet of the business on that date. There is no post completion adjustment to the figures as there is with the completion accounts. However, the buyer will be protected from any “leakage” of value between the locked box date and the actual completion date by the seller providing an indemnity.
Why this method?
This method is seen as a seller-friendly mechanism. It tends to be used where there is a strong seller’s market or at auction.
Pros and Cons
Pros
- There is certainty around the purchase price.
- It is a simple method.
- There are no costs involved in the preparation of completion accounts.
Cons
- The seller does not get the advantage of any increase in value between the locked box date and completion.
- Enhanced due diligence is more likely to be necessary, causing a lengthier transaction.
- The buyer will have to rely on the indemnities provided by the seller under the “leakage” provisions to ensure the seller does not reduce the value of the business between the locked box date and completion by undertaking certain defined actions.
3. Earn-Out
The Mechanism
This calculates the purchase price or part of the purchase price based on the performance of the business post-completion. Typically an initial payment will be made on completion and then other payments are deferred which are calculated based on the business’ future financial performance. This is usually based on profits but can be based on other financial measures.
Why this method?
This method is commonly used where the value of the transaction cannot be agreed between the parties or where the seller remains involved in the business post-completion.
Pros and Cons
Pros
- The seller receives a more accurate price for the business.
- It protects the buyer from overpaying for the business.
- The price is based on actual future performance rather than past performance.
- It defers payment for the buyer.
- It apportions the risk of the businesses future performance between the buyer and seller.
- If the seller is staying on in the business, it motivates them to maximise the performance of the business.
Cons
- There is no clean break on completion.
- It can be more likely to lead to post-completion disputes over how to measure the performance against the targets.
- External factors that cannot be controlled may affect the businesses performance such as a downturn in the economy.
- There will be increased costs for accountants and solicitors in drafting and negotiating the earn-out provisions.
- The post-completion monitoring of the performance can be time consuming.
- Depending on the length of the earn-out it could encourage short-termism and damage the long-term performance of the business.
The use of these methods will depend on the individual circumstances of the sale and purchase of the business and tax advice should be sought alongside legal advice as to which method is best suited for your circumstances.